Searching for low volatility ETFs

Although the market has recently rallied from the downward phase that ran through most of the first half of the year, many investors are wondering whether it’s time to dial back the riskier elements of their portfolios.

If you believe the “Draghi Floor” (i.e., the promise to do whatever it takes to save the euro) and the “Bernanke Put” (QE3 or QE “Infinity”) will continue to embolden market participants to pursue further equity gains, then maybe not.

On the other hand, if you are concerned that the earnings outlook is deteriorating, and that any government or central bank stimulus measures taken will continue to fall short in terms of effectiveness, finding ways to reduce your overall portfolio risk is a sensible goal.

For mutual fund managers, the answer seems to be to continue pushing people into balanced stock/bond funds. This also appears to be the only way that this industry has found to generate any equity-based sales, as overcoming investors’ broader reluctance to invest in stocks has become harder and harder, presumably in the face of underwhelming investment returns.

But getting lower downside risk by buying bonds that yield negative real rates of return after inflation isn’t my thing — particularly when considering the costs associated with the privilege.

ETF providers, meanwhile, have introduced low volatility or minimum volatility products as a way to smooth out potential bumps on the road. While looking in the rear-view mirror to select a basket of stocks based on their recent volatility levels may not be the perfect solution, it may nonetheless represent a viable strategy in that a lower volatility basket of stocks should generally reflect desirable qualitative and quantitative attributes as far as the companies included.

If so, and if, on top of that, what has been identified in some research papers as the paradox of assuming less risk yet experiencing greater returns materializes, then investors will have hit the sweet spot, which in today’s more-than-uncertain markets would be quite a feat.

There seem to be two methodologies for picking stocks to go into these ETFs. You can opt for the lower volatility stocks of an overall composite, which could result in sectors being overemphasized at different points in time if volatility is a sector-based phenomenon. Or you can choose the lowest volatility stocks from within a sector, whose weight will then be reflected within a pre-defined range. The latter option should mean greater sector diversification.

But we shouldn’t be surprised if further iterations of these low volatility/minimum volatility strategies appear. For example, factoring in implied volatility premiums embedded within options pricing (in the options market) could be a further refinement.

The more immediate considerations are whether Canadians will embrace such ETFs in numbers and does the strategy work.

Gauging from the assets that have found a home in similarly structured ETFs in the United States, Canadians should get onboard, though we seem to be lagging quite a bit.

As to whether it works, let’s compare iShares S&P/TSX 60 Index Fund (XIU/TSX) with BMO Low Volatility Canadian Equity ETF (ZLB/TSX) from the inception date of the latter.

ZLB has had a steadier and more upward path than XIU, which because of its significant material and energy exposure is more dependent on the global economic cycle overall.

Will that always be how things unfold? Critics of “low vol” strategies argue that seeking to dampen the risk side of your portfolio inevitably leads to underperformance on the way up. Looking at how well XIU has performed compared to ZLB in the past few months, it’s an argument worth noting.

A compromise could be to use lower volatility ETFs as a way to dial down risk when you see fit. Do not, if you share the underperformance concern, put all your eggs in one basket, especially if you see significant sector concentration as the primary result of the strategy.